Will financial targets agreed pre COVID remain enforceable?
Many commercial contracts include financial covenants for parties to meet after the dotted line has been signed. These might be banking covenants, earn-out provisions, milestones for payment of deferred consideration, warranties provided by sellers or any number of other financial covenants. These agreements were often entered into long before the downturn. Do such provisions now stand up?
We look at what options are open to parties who fail to meet their financial covenants in the new world order.
- General principles behind commercial covenants
- Application to commercial agreements
- The potential for re-negotiation
The general rule in English contract law is that agreed obligations are binding and absolute. Even if a change in circumstances makes performance of a contract difficult or more expensive, parties will still need to perform the contract to avoid being in breach. In most circumstances a party will be liable for a breach of contract even where performance is impossible. While we have written about possible exceptions to this rule, such as frustration and force majeure, these are unlikely to be of help to parties seeking relief from financial covenants, as the courts are reluctant to evoke exceptions purely on the basis of economic hardship.
Applying general principles to commercial agreements
The most likely commercial agreements where there could be difficulties are:
Borrowers should carefully consider whether the downturn puts them at risk of breaching any terms in their loan agreements. Reduced cash-flow might mean they miss a repayment date or breach a financial covenant. The loan agreement may also require the borrower to report material adverse changes to the lender. Where a borrower is in breach of a loan agreement, the loan will typically become repayable on demand.
What options are open to those businesses who breach loan agreement covenants?
Loan agreements do not typically include a force majeure clause. A force majeure clause is where an “act of god” renders the contract impossible to perform and allows the parties to treat the contract as over. It is unlikely that frustration will apply either. Frustration will render a contract void where its performance has been rendered impossible by some unforeseeable event. The fact that a borrower is struggling to service and repay loans under the current trading conditions is probably insufficient to establish a claim of frustration.
Negotiation of the loan agreement is often the answer
Because neither Force Majeure nor frustration are likely to apply, borrowers must carefully consider the loan agreement itself to determine a course of action. The best course may be to negotiate with lenders, who might also be able to advise on potential solutions, such as the government’s business interruption loan scheme. The best policy in this situation is open and frank communication. After all, it is usually in the lender’s interest that a borrower is able to repay its loan and interest over time, rather than being forced to repay a loan early as a result of a technical breach.
Warranties are statements of fact given by one party to another, and are common in commercial contracts such as a share purchase agreement. If a warranty turns out to be false, the innocent party may have a right to claim damages or seek an indemnity for loss that they have suffered, or potentially they may be able to pull out of the deal altogether.
It is unusual for warranties to be about future events or performance, and so parties who have already entered into warranties may believe that they are unaffected by the downturn. However, some warranties may be impacted. For instance, a warranty to the effect that there has been no material change to the business since the date of the last accounts might be affected, as might warranties which mention known or threatened breaches of material contracts by the company or its customers and suppliers. Parties should seek advice on any warranties which they have given (or received) in the months immediately prior to the lockdown to consider if and how they are affected.
Negotiation of warranties
Parties who are currently negotiating warranties will have competing priorities which may make negotiation (or renegotiation) difficult. For instance, a potential purchaser of a business may seek warranties relating to the risk presented to the key contracts of the business, or the ability of its staff to continue working. A potential seller might seek to carve out the effect of COVID- 19 from its warranties all together, on the grounds that it may affect the business in an unforeseeable way.
Earn outs and Deferred Consideration
Financial covenants in completed sale and purchase agreements are unlikely to be affected by either force majeure or frustration. Once again, parties who risk being in breach of covenants should carefully consider the wording of the particular agreement.
Sale and purchase agreements which have completed may specify that the seller is entitled to additional consideration as a result of the financial performance of the company. Some SPAs include specific wording to remove exceptional, abnormal or one-off costs from the calculation. But in most cases sale and purchase agreements signed prior to COVID-19 may be affected by the downturn.
The effect of this depends both on the drafting of the commercial agreement and the timing in question. One might suspect that the downturn might benefit most purchasers who are party to an earn-out provision, as they will not be required to pay the extra amount if their business is struggling. However, if the earn-out was triggered by financial performance prior to March 2020, but is payable now, businesses may struggle to make the required payment. We do work with buyers and sellers to navigate the options for them.
Potential for renegotiation
A common thread in this area is that, where possible, parties negatively impacted by financial covenants should seek to renegotiate. While counterparties may not be under any legal obligation to agree to amend a contract, they may take a commercial decision to do so, especially where the alternative means that a term of a contract falls unfairly on one party or the other. I have already referred to lenders being willing to negotiate so they continue to receive interest under loan payments. In the context of earn outs, a company may be willing to make adjustments to earn out provisions to ensure they are still payable in order to keep key staff incentivised. They might do this by adjusting the target levels set by the contractor and/or extending the reference period beyond that which was originally agreed.
An important caveat – new law could be introduced
In the rapidly developing situation, it is possible that the government will introduce new legislation which may, for instance, restrict the ability of lenders to call in loans early, or otherwise affect parties rights under contracts. Gannons will continue to keep a close eye, and will keep you up to date with developments.